Diversification Pains

Ukraine's dependence on export markets has considerably increased in 2014: the export to GDP ratio made 46% in the first half of the year (and will likely be even greater by the end of the year due to much deeper devaluation of hryvnia in autumn which has a negative effect on the foreign currency equivalent of the country's GDP). At the same time the current turmoil affected both the commodity and the geographical structure of the export. The changes will be shocking initially (as proceeds in foreign currency will reduce and destabilize the financial system), but they will have a positive impact in the long term, as they prompt the diversification of the commodity structure and decrease Ukraine’s dependence on markets that are unreliable for political reasons.

During the first three quarters of 2014 the export of goods shrank by 7.7%. However, this was almost entirely caused by the industrial collapse in Donetsk and Luhansk oblasts (-24.7%). In other regions the downturn is barely noticeable (-1.6%). The statistics for the third quarter demonstrate that while the export decline accelerated in the course of the year, it was largely due to the instability in the warzone regions. Their orientation on metallurgic industry, the severely outdated and uncompetitive outside the CIS machine-building, as well energy-intensive chemical industry has led to the reduction of the share of these very commodities in the overall Ukrainian export.

In August-September 2014, the share of Donetsk and Luhansk oblasts in Ukraine's industrial output (not including Crimea) shrunk to 12.3% (compared to 25.2% in 2013). This happened as a result of intensified hostilities, gradual suspension of production, and even more so as a result of suspended export of goods from terrorist-controlled territories. During the same period the share of ferrous metallurgy in Ukraine's overall export reduced from 26.6% to 22.3% (or from USD 1.38bn to USD 0.96bn), while the share of machine-building dropped from 18.8% to 13.4% (from USD 904mn to USD 577.1mn). The latter has been dragged down by the railway locomotive manufacturers, the facilities of which are located inside the zone of the anti-terrorist operation. At the same time the aircraft builders located far from the aforementioned area have increased their export share considerably, and so did the manufacturers of electrical equipment.

The percentage of foodstuffs in the export demonstrated dynamic growth (up to 31.7%). This concerns not only grains and oilseeds, but also sunflower oil, poultry and vegetables. In this case, the factor of the anti-terrorist operation only accelerated the larger trend observed since the world economic crisis of 2008-2009: the reorientation of export towards the kinds of goods, in the production of which Ukraine enjoys a natural advantage. For instance, the foodstuffs share from 2007 through 2013 increased from 12.7% to 26.8% and exceeded that of the ferrous metallurgy.

Simultaneously, the export share of industries that were historically seen as secondary in Ukraine’s economy (textile, leather, footwear, woodworking, paper, furniture, glass, ceramic industries) has increased: up to 8.9% in the third quarter of 2014 (from 6.6% three years ago). In September the revenues from paper and paperboard exports (USD 71mn) exceeded the ones from fertilizer export (USD 53mn), while exports of furniture (USD 50.5mn) or finished textile products (USD 48.8mn) topped that of railway locomotives (USD 42.9mn).

This was considerable diversification of export, which used to extensively depend on three industries: inefficient and energy-intensive metallurgy and chemistry, as well as the outdated machine-building. It looks like this trend will continue in 2015. The contributing factors will include the reduction of export of machine building products that are not competitive outside the former Eastern Bloc, as well as the main Ukrainian export-oriented chemicals, the production of which relies on the usage of imported natural gas.

Metallurgic export will primarily depend on global demand, as there are plenty of production facilities outside the zone of the anti-terrorist operation to compensate for the loss of the Donbas production capacity, should the market demand necessitate this.

The competitiveness of Ukrainian industries with large proportion of labor wages in production cost will gain from the fact that the average salary of industrial workers in China, the "world's factory" (UAH 8,800 as per the official NBU exchange rate of November 12), is several times higher than the corresponding salary in Ukraine.

The first four months of the 2014/15 marketing year (July-October) were marked by sharp increase of grain export. After the summer's drop the prices on the world market are gradually recovering, and the devaluation of the hryvnia made them all the more attractive for the Ukrainian agriculture: product cost has gone up by 30-40% for them, while the selling prices nearly doubled. Thus in 2014/15 marketing year (July 2014-June 2015) considering the expected gross yield of 62-63 million tons of grain Ukraine may export the record 36-37 million tons.

Livestock production is expected to considerably increase its export in 2015. This will be aided by the EU giving Ukrainian producers the green light to sell their output in the EU member states. Since the European Union unilaterally introduced duty-free access for Ukrainian goods (within quotas), poultry export to the EU has been growing at an impressive speed, 2.8 times in Q3’14 from Q2. Polish producers already voiced concerns regarding the emerging competition from the Ukrainian goods that currently undercut Polish prices by more than 50%. Export of other livestock products, first and foremost dairy and eggs, to the EU is likely to increase as well.

Diversification of exported goods, the signing of the Association and the Free Trade Area Agreement with the EU, and especially the loss of industrial capacity in the Donbas along with harsher trade restrictions imposed by Russia created the conditions for Ukraine's relatively painless withdrawal from the post-Soviet export markets.

In August-September 2014, when the abovementioned factors gained prominence, Ukraine's export to Russia was 40.5% less than the corresponding figure for the same period of 2013. The Russian Federation's share in the overall Ukrainian export dropped to 16.9%, or 23.2% if one takes into account Russia's satellites that are to become its fellow members within the Eurasian Economic Union (Kazakhstan, Belarus, the Kyrgyz Republic and Armenia). For comparison: export to the EU during the same period hit 28.9%, other export amounted to 47.9%.

At present the loss of the entire Russian market would make less of a difference than its reduction in the course of the previous three years: in Q3’14 Ukraine's export to Russia made USD 2.4bn, compared to USD 5.4bn during the same period of 2011. If this trend is to continue in 2015, by the time the Free Trade Area agreement with the EU fully comes into force (January 1, 2016) and the CIS FTA is potentially discontinued , the Russian share in Ukraine's export may well be down to 10-12%.

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